In China, OPEC’s nightmare comes true

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– John Kemp is a Reuters columnist. The opinions expressed are his own –

China’s decision to link domestic fuel prices indirectly to the international crude oil market, subject to a price cap, while hiking the consumption tax on gasoline and diesel and phasing out a variety of road tolls and other fees shows Saudi Arabia’s worst fears about high prices and demand destruction are starting to come true.

It seems likely to confirm the kingdom’s determination to see prices stabilize around $75 per barrel, well below recent price peaks, and far below the level sought by some other OPEC members, as well as international oil companies and advocates of alternative energy.

China is among the world’s most inefficient users of energy, measured in terms of BTUs consumed per dollar of GDP produced.

Since China’s economy is one of the largest and fastest growing, and heavily reliant on imported crude oil, China has been hit harder than any other country by the recent surge in oil and energy prices.

Rising energy prices have worsened the country’s terms of trade, and threaten the viability of much of the industrial base (including the power-intensive steel and aluminum industries).

The central government has made reductions in energy consumption per unit of output a top priority.
Policymakers have used investment controls and other administrative measures to try to limit the expansion of energy-intensive industries aimed at producing primarily for export.

At the same time, export taxes have been introduced on a wide range of low-value added semi-manufactured products (such as unwrought aluminum) and VAT rebates scaled back to encourage the manufacturing sector to concentrate on exporting higher value-added items in which energy is a smaller fraction of the overall unit cost.

But efforts to increase energy efficiency have been only partially successful, because the government continued to hold prices for gasoline, diesel, thermal coal and on-grid electricity below international levels, using a combination of price controls and subsidies. The government’s strategy for improving energy efficiency came into conflict with the priority on economic and social stability.

Extensive price controls and subsidies largely insulated households and businesses from the rise in international oil and energy prices, blunting the incentive to improve energy efficiency.

Eventually, the rise in global oil prices became overwhelming. The resulting pressure on the current account of the balance of payments and need for growing subsidies to the country’s oil refiners forced the government to raise administrated gasoline and diesel prices almost 20 percent earlier this year.
One welcome effect of the rise in oil prices and the decision to increase domestic gasoline and diesel charges was that it sharpened incentives for energy efficiency considerably.

But as the economy has slowed sharply and international oil prices have tumbled, the government has come under pressure to cut fuel charges.

Instead, the National Development and Reform Commission (NDRC) has introduced a carefully integrated package of measures designed to provide short-term economic relief while maintaining the pressure for greater energy efficiency in the medium term.

By linking domestic prices indirectly to the international oil price, NDRC has ensured that consumers and businesses will benefit from the current easing in the oil market, helping stabilize the economy, but that domestic prices will move up again if the market picks up, reducing the subsidy burden and maintaining market-based incentives to limit energy consumption.

More importantly, the government has taken advantage of the (possibly temporary) reduction in oil prices to introduce a (probably permanent) increase in the energy consumption tax.

The key point is that the consumption tax is not linked to variations in the oil price and will sharpen the incentives for using energy more efficiently at any level of international prices.

In effect, China has started to emulate the successful conservation strategies used in Europe and Japan, where heavy fuel taxes have spurred the use of much more fuel efficient vehicles and much lower energy consumption per unit of output than in the United States and the rest of the world.

Europe and Japan took advantage of relatively low oil prices during the late 1980s and 1990s to raise substantial excise taxes on the consumption of gasoline and diesel. China’s decision to boost the consumption tax on gasoline and diesel looks like it could be the first in a series of phased increases over time, similar to the United Kingdom’s “fuel duty escalator.”

OPEC has long complained about the massive “wedge” these fuel taxes have driven between the pump prices paid by motorists in Western Europe and the net revenue which oil exporting countries actually receive for their crude, but they are widely cited as the most effective conservation strategy.

Saudi Arabia expressed consistent concerns that the recent surge in oil prices would lead to the long-term loss of demand even if prices subsequently fell back. Those fears are now being realized.

China’s decision to raise the fuel consumption tax is one of a number of measures adopted around the world to promote conservation and aimed at the volume of oil consumed for any given level of prices.

It is consistent with the massively increased bio-ethanol blending requirements introduced in the United States last year designed to displace oil consumption.

By pushing energy conservation to the top of the policy agenda, the frenzied escalation in oil prices during 2006-2008 is set to have long-lasting effects, even if prices eventually stabilize at much lower levels. President-elect Barack Obama has made clear that improving energy efficiency and cutting dependence on oil imports will be a top priority in the next four years.

Neither the incoming Obama administration, nor top planners in Beijing, will quickly forget the harsh lessons about reducing energy dependence taught in the last two years, even if prices now settle much lower.

China’s decision to raise fuel taxes will increase Saudi Arabia’s determination to stabilize prices at a much lower level than most other members of the organization are comfortable with, to try to limit the long-term damage to oil demand.

The kingdom’s worst fears about the long-term damage wrought by high and volatile prices are now being realized.

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John joined Reuters in 2008 as one of its first financial columnists, specialising in commodities and energy. While his main focus is on oil markets, he has written broadly on the emergence of commodities as an asset class, regulatory issues and macroeconomic themes. Before joining Reuters, John spent seven years as a senior analyst for Sempra Commodities (now part of JP Morgan) covering base metals and crude oil. Previously, he worked as an analyst on world trade, banking and financial regulation for consultancy Oxford Analytica.